National Institute of Economic and Social Research

Tuesday, 27 March 2012

It's not too late to change course: Macbeth and fiscal policy

I appeared before the Treasury Committee today to discuss the Budget. As usual, we were asked about the government's macroeconomic strategy, and the case for a change of course. Two of my fellow witnesses, Jens Larsen and Roger Bootle, said that while they thought that there was a strong case that the government's fiscal consolidation programme was too aggressive - that is that we would be better off now had the scale of fiscal tightening in the first year or two been less - that the risks of changing course now outweighed the benefits. [Note for the record: I hope I am paraphrasing them fairly; they are both excellent economists, and I agreed with most of what they said to the Committee].

I described this as the "Macbeth argument", from the following quote:

"I am in blood stepped in so far that should I wade no more, Returning were as tedious as go o'er." [Act III, scene iv.]

In other words, since Macbeth has already killed Duncan and Banquo, it is better to carry on (and order the deaths of Macduff and his family) than to stop. So, although misguided policy has led to unnecessary economic damage, that damage is (returning to economist speak) a sunk cost; and the pain ahead is less then the pain that we would suffer if we changed course, as a consequence of the possible negative financial market reaction.

The Treasury also appears to subscribe to a variant of this argument. When the original fiscal consolidation plan was welcomed by the rating agencies, that was a vote of confidence:

"

Standard & Poor's, the ratings agency, revised its outlook
on Britain from negative to stable..The Chancellor said: ""That is ..
a vote of confidence in the Coalition Government's economic
policies.." Telegraph, 26 October 2010

But when the same rating agencies realised the damage the plan was doing to growth, that made it even more necessary:

"Fitch revised the outlook on the UK's rating to negative from
stable...."A week from the Budget this is a reminder of why it is
essential Britain sticks to its plans to deal with its debts," a Treasury
spokesman said..." Telegraph, 14 March 2012

Even leaving aside the obvious inconsistency here, I remain of the view that this argument is incorrect, for three reasons:

As I argued here, I don't think it's plausible to argue that markets have more confidence in governments that never adjust policy even when it is sensible to do so. Markets can be irrational. But there is neither a theoretical reason nor any empirical evidence to suggest that they are irrational in this particular way. Indeed, history suggests the opposite: that the real hit to credibility comes from sticking to unsustainable policies – think Argentina in 2001 or Britain in 1992. Nor does the argument that if the government adjusts its strategy, markets will lose all faith in its ability to consolidate at all, carry much weight: Simon Wren-Lewis explains why here;

the downside risks are hugely overstated, as I've argued consistently, and as the (non)-reaction to the moves by the rating agencies has demonstrated.

most importantly, the negative consequences of continuing on the current course - the costs of inaction - are considerably understated. According to the OBR's latest forecasts, the economy will still be producing well below potential even in 2015 - and, as a direct consequence, unemployment will remain well above the natural rate. 650,000 people who could and should be in jobs - if the economy was on track - won't be.

And this in turn will do damage that will last not for years but for decades. As the research that we and others conducted for the ACEVO Commission on Youth Unemployment showed, the potential long-term economic and social damage that is likely to result from the current levels of unemployment, especially youth unemployment, is huge.

The implications of this for fiscal policy are set out in an exceptional - and exceptionally important - new paper by Brad Delong and Larry Summers. They analyse the impact not just of fiscal multipliers on short-term growth, but on the long-term implications that flow from hysteresis effects - ie the long term damage done to an economy's productive capacity by restrictive fiscal policy in the short term. They show that, when interest rates are very low, you only have to assume very modest hysteresis effects indeed to justify short-term fiscal expansion. Their conclusion is worth quoting at length:

Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero bound.

In other words, in economies like the US and UK, the case for rapid consolidation is exceptionally weak. Although multipliers in the UK are undoubtedly lower than in the US, the evidence for substantial hysteresis effects is probably rather stronger; the basic logic still holds.

It is for this reason - the long-term economic, social and even fiscal damage being done by current policy - that I favour a change of course. Returning to Macbeth: of course, his argument was wrong. Much more blood is shed after this scene than was before (including his own and that of Lady Macbeth). Of course, we don't know what would have happened if he'd adopted an alternative strategy, but it seems highly probable that both the short and long-run outcomes would have been preferable.

I agree with the thrust of the argument being presented and the attention being rightly drawn to the Summers & DeLong piece. Not sure about calling Roger Bootle an "excellent economist", self-publicist definitely and he does do a good turn.

But, "when the same rating agencies realised the damage the plan was doing to growth that made it even more necessary" seems disingenuously too kind to the rating agencies or as Fitch put it in the immediate run up to the budget when they downgraded their outlook on Britain to negative: "The triggers that would likely prompt a rating downgrade" include "Discretionary fiscal easing that resulted in government debt peaking later and higher than currently forecast"

I read this statement as Fitch stating less austerity could equal a downgrade. Fitch may well disagree with the consequences of austerity, however, they don't appear to disagree with austerity itself.

We all know the current Government has an obsession with public sector debt. It is patently obvious the economy needs stimulating and the Tories only excuse for £150 billion of fiscal tightening in the teeth of a stalled economy is that There Is No Alternative.

The crazy thing is that there obviously is an alternative. Sitting in a wholly publicly owned subsidiary of the Bank Of England called the Asset Purchase Facility (APF) is £324 billion -over a third - of the UK Governments outstanding debt.

Cancelling the debts would be straightforward. The APF just retires the Government debts it is holding by communicating that the gilts no longer exists. Job done. No effect on the UK money supply. No raised inflation. No effect on investor confidence. You and I, the tax payer, just don't have to suffer another £200 billion of "austerity".

The only way not to monetise the debt is for the APF to opt to sell the gilts it is sitting on back into the private sector at some point in the future. And here is the kicker - to then cancel the cash it receives for selling the debt by ripping up the money paid to it. This would nullify the £324 billion of QE lent to it from the Bank of England to buy the gilts in the first place but is obviously an act of treason and total insanity. What kind of people contemplate ripping up £324 billion of publicly owned money?

The Bank of course emphasises that as a principle it will not monetise the gilts the APF owns. Again and again the Gov'nor pleads that he is not being forced to create money in order to cover the gap between the government's tax income and its spending commitments. Very sensible of the Bank to emphasise this as if this was what was happening, it would be a violation of Article 123 of the Treaty on the Functioning of the European Union. Rather, the Bank promises us that it is undertaking quantitative easing in order to meet its inflation target and will sell the government debt back to the private sector once the economy recovers, thus unwinding the original increase in the money supply.

Apart from this being treasonous and insane the flaw in this argument is that there is absolutely no prospect of the Bank selling the gilts in the APF in the future.

But how on earth could the Government fund its future normal gilt issues when the Bank was simultaneously dumping an additional £324 billion worth of gilts from the APF onto the market? Leaving aside the nonsense that Governments can run surpluses as a routine policy, the APF certainly won't be able to dump its stock of bought up gilts whilst the UK Government is running a deficit. The deficit is forecast (optimistically) all the way out to 2017 and beyond.

So if the unwinding of QE can't happen whilst the UK Government will still need to borrow, can it happen in a hypothetical future when the deficit is paid off? In this impossible future the private banking sector will have to be creating enough lending to allow the money supply to widen at its normal rate. Dumping an additional £324 billion of interest bearing gilts out on the market is at best futile and at worst will restrict growth if timed badly.

Inflation can be caused by a widening of the money supply is indeed possible. This is what happens in "normal" recessions. The bank raises policy interest rates to choke off the money supply when demand is overheating the economy. Of course there is no risk of this now. At some hypothetical point in the future there might be a risk of banks widening the money supply too quickly again. But credit creation by banks is not resource constrained and the extent to which they do this if the economy ever recovers again will have nothing to do with QE reserve crediting that happened 5 years before.

And anyway with policy interest rates at 0.5% and contingent capital ratios so low there are other perfectly viable ways of taming any future inflation if we are ever so lucky as to emerge form the current slump. The Bank can increase policy rates or insist on higher capital buffers in the banks.

So for now we are left with a ridiculous situation where the Tories are moaning about the huge and "unaffordable" government credit card bills. At the same time over a third of the debt they are moaning about is stuck in the Government owned Bank of England with no hope of it ever being anything other than cancelled and retired. To add to the hilarity the Treasury, through a wholly government owned agency called the Debt Management Office pays interest on the £324 billion in the APF to the wholly government owned APF. This money is just building up and will eventually (as all profits for the Bank are) be returned to the taxpayer. You couldn't make this up.

Is this the future you want - where the Bank sells Government debt back to the private sector at some point in the future, reducing growth, and then simply rips up any cash it receives in order to demonstrate a point of principle?

Please have a thinka bout this Joanathan and if you agree with it raise it as an issue- somebody needs to.